How does the CfD Work?
The CfD has two key features to attract a large pool of investors and get them to invest at the lowest cost.
A CfD guarantees that the low carbon generator will receive a fixed price for the electricity it sells into the market. This gives generators and their investors price certainty throughout the length of the contract, usually 15 years.
This protects electricity generators and their investors from future political interference in the CfD price. It also ensures that generators will receive their CfD payments if they meet the terms of the contract.
As a result, investors can rely on projects to deliver stable returns. This reduced risk increases the appeal to a wider pool of investors, driving competition to invest at a lower cost and reducing consumer bills.
Lowering the cost of capital – why does it matter?
Underwriting the risk to reduce the cost of capital is key to lowering the cost of decarbonisation. Without this:
- developers would have to borrow at higher interest rates and charge consumers more for their electricity
- fewer low carbon plants could be built
- less green energy would be generated because the higher costs of borrowing the reduce the number of low-carbon generation plants built.
Our governance arrangements ensure that the generator is always paid. This further reduces the risks and costs.
How are generators paid?
CfD generators receive a fixed price for every unit of electricity they produce. This is called a strike price.
In return, the generators agree they will never get paid more than the strike price, even if the market price is higher.
This chart shows how the CfD strike price interacts with the market price to ensure a fixed revenue. It also explains how the money flows and how the cost to consumers is always the strike price.
This makes a big difference to generators because the market price is highly volatile. It changes every half hour depending how much electricity demand there is and the cost of the generation to meet that demand.
These generation costs are themselves affected by the price of the fuel used in some power stations. Despite these variations, under the CfD generators never receive more than the strike price.
It is very difficult for anyone to forecast what this market price will look like more than a few years ahead, let alone over a project’s lifetime, which can easily reach 25 years. As a result the CfD is a very powerful price stabiliser, giving both investors and consumers long term protection from price volatility.
How is the strike price set and managed?
If the strike price was set too high, generators would make money at the expense of consumers. To keep the price fair the Government holds auctions, also referred to as Allocation Rounds. Competition between projects to secure a CfD leads to lower prices for consumers.